As On: Dec-03-2024 | 09:47 PM
Central Bank Digital Currencies
Published February 28, 2022With these pieces of paper they can buy anything and pay for anything.
All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece a variety of officials, whose duty it is, have to write their names, and to put their seals
Marco Polo on seeing paper currency in China
Heat is a great crime movie. The bank heist scene is an epic and a cinematic tour de force. It gives you a visceral jolt: bullets, carnage and gateway cars with bags full of cash feature prominently.
Bank robberies with cash have been an integral part of cinematic zeitgeist and any heist movie worth its salt, be it the modern The Town or classics like The Killing had lucre as center piece.
However, with the onslaught of digitalization the paper currency may be reaching its logical demise. The arguments for its demise have been vociferous.
It is sweetly ironic that the pioneer of paper currency China just like in Marco Polo’s days may also lead its demise.
Both China and Sweden are in advanced stages in terms of conducting tests for Central Bank Digital Currency (“CBDC”). Both countries have seen the use of physical cash rapidly disappear due to the high penetration rate of smart phones and electronic payments.
But why the sudden impetus for CBDCs now? There are two reasons:
1. The blockchain technology pioneered by Bitcoin has proved its concept and resilience (more about it later).
2. The second and main reason besides cryptocurrencies going mainstream was the announcement of Facebook to launch a cryptocurrency called Libra in mid-2019.
Libra project was literally the straw that broke the camel’s back. Central Banks hate losing control over their money and the ensuing transmission mechanism of monetary policy. The Libra cryptocurrency was to be backed by a basket of reserve currencies and built on the blockchain. The currency would have been available to billions of Facebook users and though not officially admitted could threaten the national currencies like the US dollar and financial markets.
The Libra project has officially been shelved now after the regulatory pushback.
What is Central Bank Money?
Before we go into the complexity and architecture of CBDCs let’s take a detour to explain what is money and what is precisely meant by Central Bank money.
For a layperson, money conjures images of tangible white paper bills with pictures of dead presidents/prime ministers or other cultural emblems. However, cash or paper currency is one small part of what we technically call money.
Contrary to popular misconception Central Banks do not create money. The actual money in economy is created through intermediaries: we call them “commercial banks”. Money is created when banks create credit through loans, overdrafts etc.
The key take way is that the supply of money is determined primarily by the demand of borrowers to take out bank loans. Banks provide the supply that meets this demand.
Money consists in three forms:
1. Physical currency i.e. cash banknotes and coins. This type of money is a Central Bank liability.
2. Central Bank reserves- reserves held by commercial banks at the Central Bank. Central Bank is a banker to commercial banks, so the latter hold the reserves at Central Bank to facilitate interbank payments. The important thing to note is that this is the only “money” which Central Banks can target directly. They can credit reserves in commercial bank accounts by buying assets (e.g., treasuries) from them. This type of money is also a Central Bank liability.
3. Commercial bank money – bank deposits created when commercial banks create credit. In creating credit, banks simultaneously create brand new deposits in our bank accounts, which, to all intents and purposes, is money. This money is a liability of the commercial banks.
#1 and #2 are called M0 or base money. On this base money banks create credit and hence money is circulated in the economy.
So far, we have established that Central Banks have no connection with end users of money except via physical cash: everything is intermediated through commercial banks. Individuals do not keep bank accounts at Central Bank-only commercial banks do. The only Central Bank money we as individuals hold is physical currency.
What exactly is CBDC?
Now that we have explained what money is and where does it come from, lets discuss what is supposed to be meant by CBDC.
Our current monetary set up is a digital accounting of money, which is a claim on an intermediary (commercial bank). When we shop online or use our debit card, we are basically using the electronic representation of physical money or money created by commercial banks. A cashless economy can exist without CBDC by making account-based system completely digital.
Sweden is already on its way towards a completely cashless society without CBDC. China is also pretty much cashless now and Alipay and WeChat dominate the digital payments landscape.
China bypassed the credit card rails enabled by the ubiquitous adoption of Ali Pay and WeChat. They account for 90% of the China’s “digital” payment market.
CBDC will most likely replace cash money i.e., money definition # 1 so there will not be any physical notes with dead presidents/prime ministers.
The more interesting issue is what will happen to reserves and bank deposits i.e., money definition # 2 and #3? That’s where things get interesting and a bit confusing. Bank deposits are a claim on the banks whereas CBDC will be a claim on Central Bank.
There are two broad potential models of CBDC.
1. Direct retail CBDC: Every citizen will have an account with Central bank, which will process every transaction between the counterparties. To be honest this is impractical. Central Banks will not want to be turned into retail banks. Furthermore, this model will disintermediate the entire banking sector.
2. Wholesale CBDC: In this model, some select account holders (most likely banks and may be other counterparties) will have accounts at Central Banks.
Both these models can be turned from “account based” to “token based”. To understand we need to delve into the blockchain technology.
CBDCs are beholden to the underlying blockchain technology but in spirit they are totally different. The currency will be tokenized via UTXO, whereby the Central Bank no longer has to monitor accounts for every individual. Once tokens are issued, the tokens themselves pass between market participants, and the Central Bank’s responsibility is limited to running the blockchain system that issues, redeems, and follows the flow. With tokenization implementation, the overhead to maintain extensive database and IT infrastructure will be minimized.
In short, CBDC will be based on blockchain technology, but it will not be decentralized like Bitcoin.
All blockchain technologies face a trilemma. Any blockchain needs to balance competing demands of decentralization, scalability, and security. For example, Bitcoin is decentralized and secure but not scalable (There are efforts underway to scale it up via Lightning Network but that’s another discussion altogether).
CBDC will be most likely based on a centralized blockchain.
CBDC could theoretically be transferred between counterparties via an “approved” digital wallet.
So, the banks who have always intermediated between end users and central banks could face more competition like what happened in China.
For instance, in China both Alipay and WeChat are payment channels and will continue to use digital Renminbi when it comes into play. Though they might have a competition from other “approved Central Bank wallets”.
In essence new digital wallet application may be created which will be linked to the CBDC account through APIs.
With CBDCs, we can make direct digital payments without our data passing through a long chain of financial intermediaries.
Why are Central Banks keen on CBDC?
Central Banks are keen on CBDC because it will give them more control than what the current monetary system allows:
1. Control of monetary policy: The monetary policy is transmitted via a complex web of intermediaries and is more of an art than science. CBDC will enable central banks to literally drop money via helicopter. Imagine having US$100 instantly credited in your account.
2. Prevention of tax evasions and illegal usage: Physical cash is one of the main sources of tax evasion. It is also one of the preferred instruments to hide illicit gains. CBDC will make it extremely difficult (not impossible since humans have ingenious capability to come up with counter schemes) to pull a Walter White act.
3. Financial inclusion: A lot of people in developing countries do not have access to banking facilities. All you need for CBDC is a mobile phone and not even an internet connection if it has NFC facility. During Covid even a developed country like USA had to send stimulus payments via cheques. CBDC will make any payments to citizens instantaneous and targeted.
What are the potential risks?
Privacy is one of the main issues cited. But I think the ultimate design will differ from country to country. Without privacy, I am not sure CBDC could gain traction. There might be some top-down pressure in countries like China but in Western democratic system, a CBDC without privacy guardrails will not fly.
In fact, US Federal Reserve has explicitly stated its CBDC to be “privacy-protected, intermediated, widely transferable, and identity-verified”.
Who will be the winners and losers?
The winners besides Central Banks will paradoxically be cryptocurrencies. They will gain additional respectability and Bitcoin might become boring and mainstream.
The losers will be banks. They have already been losing to Alipays, WeChats etc. They are increasingly becoming dumb pipes over which other parties are building APIs via open banking regime. However, as mentioned above most central banks will be keen for CBDC to complement the current money system.
Credit card like Visa and Master Card companies could be vulnerable to disruption by CBDCs. Their debit card products will be more vulnerable.
The topic of CBDCs is evolving rapidly and we hope to see many interesting developments in the future. The essay is just a first attempt to capture the big discussions.
Author: Ali Asad, CFA | Strategic Advisor, Alpha Capital
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